Fed signals rates will remain low

European debt crisis affecting outlook

WASHINGTON (MarketWatch) -- The Federal Reserve kept interest rates on hold at a record low near-zero on Wednesday for the 18th straight month and said the European debt crisis was negatively impacting the recovery.

In a statement at the end of its two-day meeting, policy makers downgraded their outlook for the economy, saying that the recovery was "proceeding" -- not strengthening as they had said in April.

The Fed maintained its commitment to keep "exceptionally low levels of the federal funds rate for an extended period."

"Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad," the statement said.

'Financial conditions have become less supportive of economic growth on balance...'
FOMC

The Fed is clearly referring to the financial turmoil this spring as a result of the European debt crisis. Even with interest rates at low levels, financial markets have exhibited several bouts of stress since the last Fed meeting, as investors worried whether Greece or other small European countries might have to restructure their debt and which banks or other creditors might suffer losses as a result.

"They are really sticking it to the Europeans," said Robert Brusca, chief economist at FAO Economics.

Brusca said it looked like the Fed was joining the Obama administration's fight to get Europe to delay fiscal belt-tightening until the global recovery was stronger.

Financial markets seemed to like the tone the Fed struck in the statement. While there was concern about the outlook, it was not so severe to spook investors, analysts said.

"The Fed's confidence in the economic recovery does not appear to have been significantly shaken," said the economic team at RDQ Economics.

The Dow Jones Industrial Average
DJIA, +0.08%
was recently up 3 points to 10,296.

Treasury prices rose on Wednesday, pushing long-term yields to the lowest levels in a month

Yields on 10-year notes
TMUBMUSD10Y, +0.00%
declined 5 basis points to 3.12%, after having touched the lowest level in a month earlier.

In addition to worries about the impact of a weak Europe on U.S. growth, economists said the Fed will not move until it is certain that the budding recovery can stand on its own after government stimulus is removed.

This remains an open question.

Sales of new homes plunged 33% in May to a record low level after a federal subsidy for homebuyers expired. See full story.

Earlier this month, key data on employment and retail sales were also soft.

In another downgrade to the outlook, the Fed said housing starts "remain at a depressed level" In April, the Fed had also noted starts had "edged up"

The Fed has kept rates near zero since December 2008, hoping to spur growth. At some point, the Fed will have to engineer an exit from its easy monetary policy.

Fed watchers are now predicting that the tightening cycle won't come until the middle of next year. The Fed will be reluctant to raise interest rates while there are so many Americans unemployed. With inflation low, there is little pressure on the Fed to alter its policy stance.

In its statement, the Fed pointed out that prices of energy and other commodities have declined in recent months and underlying inflation has trended lower. Inflation is likely to be subdued "for some time," policy makers said.

Recently, analysts have begun to wonder what the Fed would do if the economy were to slip back into recession.

The Fed gave no hint about what it would do to combat renewed weakness. The central banks could re-start purchases of mortgage-backed securities and other housing-related securities. The central bank completed its purchase of over $1 trillion in housing securities in March.

Thomas Hoenig, the president of the Kansas City Federal Reserve Bank, dissented for the fourth straight meeting. Hoenig wants the Fed to back away from the "extended period" pledge. He argues that the expectation of low rates for a long period could lead to asset bubbles and ties the Fed's hands to raise rates modestly.

Still, the signal from the Fed's majority is that policy will remain steady.

"Cleary the Fed sounds like it is even more on hold. The statement was dovish and Hoenig seems more isolated than ever," Brusca said.

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